Growth and Business Cycles

The two central issues of macroeconomics are evident in Figure
1, time series graph of real
GDP (Gross Domestic Product) in the US
over the last forty years. As we'll see shortly, GDP is a measure of
total
production of goods and services in an economy, the US being one
example.
The two obvious features of postwar GDP are its upward trend (GDP has
generally
been increasing over the postwar period) and the short-term
fluctuations
or "wiggles'' in this generally upward-sloping line. We refer to these
two issues as economic growth and business cycles,
respectively.
When you look at data over periods this long, the wiggles don't look
very
important, and in a sense they aren't: the short-term fluctuations are
a small part of the wealth of nations. But from a personal point of
view
these cycles can be very important, as businessmen and workers dealing
with the latest 2001 recession could tell you. We'll look
at both growth and cycles in this course.

The classical question of economic growth is why some countries are
richer and/or grow faster than others. (The two are clearly related,
since
countries that grow faster will eventually be richer.) Some examples
are
given in Figure 2, which graphs per capita GDP for three countries over
the postwar period. [All are measured in 1980 US dollars.] This figure
differs from the previous one, since I've expressed output in per
capita
(per person) terms by dividing GDP by population. This produces a more
meaningful comparison between countries, since countries with more
people
don't automatically have higher numbers.

Figure 2 illustrates a number of differences among
three countries: Japan,
Argentina,
and the US. Perhaps the most obvious feature is that the US is the
richest
country: by this measure in 1985, it was 30 percent richer than Japan
and
almost three times as rich as Argentina. These are averages so they
ignore
a lot of differences at the individual level, but they give you some
idea
of where these nations stand economically. The comparison with
Argentina
gives us an idea of the enormous differences between rich and poor
countries.
In fact, Argentineans are relatively well off, roughly five times
better
off than an average person in India. But the truly remarkable country
is
Japan. In 1913 Argentina was about 3 times richer than Japan, now it's
the opposite. Japan's remarkable performance has lasted, thus far, for
over a century. Argentina, on the other hand, has gone from one of the
richest countries in the world at the turn of the century to an average
Latin American country economically that experienced a severe economic
and financial crisis in 2001.

Figure 3 does the same thing for the US, China,
and
Korea, where again we see sharp differences between countries. China
used to be one of
the poorest of these countries but for the last 20 years China has been
among the most rapidly growing countries in the world.
Combined with China's enormous population, some estimates suggest that
China is now the world's third largest market.

These comparisons are so striking I find it hard to leave them, but
let's turn our attention to the other aspect of macroeconomics,
business
cycles. From a business point of view these short-term movements in the
economy are of more immediate concern. You may want to know, for
example,
whether the economy will be in better shape when you finish your degree
or whether your airline stock is going to be worth anything in 12
months
(airlines are notoriously sensitive to recessions). You get a much
better
picture of the short-term fluctuations in Figure 4,
where
we graph annual
growth rates of US GDP.

By annual growth rate, I mean the "year-on-year'' growth rate in
quarterly data,

(GDPt - GDPt-4) /GDPt-4

where GDPt is GDP in quarter t (for example the third
quarter
of 2005) and GDPt-4 is GDP four quarters before (for
example
the third quarter of 2004). Viewed from this perspective, the
short-term
movements seem a lot bigger than they did in Figure 1. For the postwar
period as a whole the average growth rate of 3.3 percent per year is
swamped
by the year-to-year variations. [Statistically, we could say that the
mean
of 3.3 percent per year is only slightly larger than the standard
deviation
of 3.0 percent. A plus or minus two standard deviation interval is thus
(-2.7,9.3). If you find this mysterious, review your statistics notes.]
The nine downward spikes, all of which touch or pass the axis, are the
nine postwar recessions, defined most simply as two consecutive
quarters
of declining GDP. The National Bureau of
Economic Research, the de facto arbiter of business cycles in the
US,
has decided that the troughs (the bottom point) of these recessions
occurred
in November 1949, May 1954, April 1958, February 1961, November 1970,
March
1975, July 1980, November 1982, April 1992 and November 2001.

Note that in Figure 4 the growth rate of GDP is defined as
year-on-year
growth rate of quarterly GDP. Note that there is an alternative way to
define the growth rate of the economy: this is the way the growth rate
of GDP is usually reported by the US
Government and the press. It consists of measuring the growth rate
of GDP in a particular quarter relative to the previous quarter and
annualize
such quarterly rate of growth by multiplying by four. Accordingly, the
quarterly growth rate of the economy at an annual rate (AR) is:

4 x [(GDPt - GDPt-1) /GDPt-1
]

Figure
4' shows the growth rate of GDP according to this alternative
measure.
As a comparison of figures 4 and 4' shows, the second way of expressing
the growth rate of the economy implies a greater volatility of output
growth
as quarterly changes in the rates of growth are amplified when measured
at annualized rates. As the annualized quarterly growth rate gives a
better measure of the very
recent performance of the economy, this is the measure usually reported
in the press and most closely analyzed in the business and financial
sector.
However, the year-on-year definition gives a better measure of the
growth
rate of the economy over a longer period, i.e. how the economy has
actually
grown over the last 4 quarters. A similar distinction between
year-on-year
growth rate and annualized quarterly growth rate holds for the other
macroeconomic
variables. To create quick charts of macro variables using these
alternative
definitions, you can use the Economic
Chart Dispenser available on the Web. Tables
with the most recent GDP data is available from the Bureau
of Economic Analysis at the Department of Commerce. For more
information
on specific macroeconomic variables see the course homepage on the Hyptertext
Glossary of Business Cycle Indicators.

One question you might ask is why the economy experiences such large
short-term fluctuations. We'll return to this later in the course. For
now let me just say that recessions happen: business cycles have been a
property of all economies for as long as we've had data and, despite
what
politicians tell us, they show no sign of going away. You can see signs
of cycles in other countries in Figure 5. In Figure
5 I report growth rates of real GNP (total, not per capita) in
Germany
and Japan, where we see that they, too, have had substantial
fluctuations,
despite their higher average growth rates. For Japan, though, there
would
be only recessions between World War II and 1990 if we defined a
recession,
as is typically done in the US, as negative growth. Note, however, that
in the 1990s, Japan experience a period of protracted economic
stagnation.
The average growth rate per year was close to zero between 1992 and
1995.
Growth recovered in 1996 but such recovery fizzled in 1997 when the
economy went again into a slump. The weak economic performance of Japan
in the 1990s and 1997 in particular contributed to exacerbate the 1997
economic crisis in East Asia: as Japan is a leading export market for
many
East Asian countries, the stagnation of growth in Japan in this decade
led to a reduction (since 1995) in the export growth rate of many East
Asian countries.

Gross Domestic Product

Today we're going to go behind the scenes, as it were, and review some
of the measurement issues that lie behind concepts like GDP and GNP.
The
goal is to gain some familiarity with the most important macroeconomic
indicators so that we know something about their meanings, strengths,
and
weaknesses. We'll start with an accounting system analogous to the
income
statement used by firms: the National Income and Product Accounts
(NIPA)
constructed by the Bureau of
Economic
Analysis at the Department of Commerce. In many respects this
system
is like financial accounting systems for firms and, in fact, relies
heavily
on reports made by individual firms to the government. It's also like
firm
accounting in that one needs to use some artistry to make sense of the
numbers.

Our first goal is a measure of overall production, which we will
refer
to as Gross Domestic Product, or GDP. Gross National Product, or GNP,
is
closely related. Both are measures of the total production of goods and
services of the US economy for a particular time period---say, the year
2004 or the first quarter of 2005 (January through March). We
will discuss
below the difference between these two measures.

We can think of total production in the US as the sum of production
by all the individual firms, but there's a subtlety here that we can
illustrate
with a simple example. Consider a firm that assembles PCs from parts
made
in Taiwan. Its only other expenses are labor. Let's say that the firm's
income statement looks something like this:

Sales revenue 40,000,000

Expenses 26,000,000

Wages 20,000,000 Cost of Parts 6,000,000

Net Income 14,000,000

The question is how we measure this firm's contribution to US output.
The
straightforward answer is 40m, the total value of its sales. But if we
think about this a minute we realize that 6m of this was produced
somewhere
else, so it shouldn't be counted as part of the firm's---or the
US's---output.
A better answer is 34m, the amount of value the firm has added to the
imported
parts. This principle is applied throughout the NIPA: we take
value-added
by everyone in the economy and add it up to get GDP. When we sum across
firms, we only count the value added by each one. US GDP is total
value-added
for the US economy.

Another way to compute value-added is to sum payments to labor and
capital.
In this case we add 20m paid to workers to 14m profit that goes to
owners
of the firm---capital. That gives us factor payments of 34m, the same
number
we found above using a different method, factor being a term used by
economists
to mean inputs

The term value-added has the connotation that the prices that
underlie
the firm's income statement reflect economic value in some deeper
sense.
When we compared the GDP's of three countries earlier we presumed that
the country with the larger per capita GDP was richer in some useful
sense.
But suppose they produce different goods. Suppose country A produces 10
billion apples and country B produces 10 billion bananas. Which is
richer?
We generally assume that if apples are worth more than bananas then
country
A is richer. The idea is that market prices tell us which is more
valuable,
apples or bananas. The same thing underlies our measurement of
value-added.
Suppose, to make this concrete, that the 40m sales of our fictitious
company
was 20,000 PCs at $2,000 each. Our presumption is that the market price
of $2,000 reflects economic value and we use it as part of our
calculation
of GDP. In some cases this isn't so easy. In, say, North Korea (or
until
recently, China), prices do not generally reflect market forces, so
it's
not easy to calculate economic values. There are also some subtle
issues
in market economies about how to value nonmarket activities like
government
spending, housework, pollution, and so on.
I promised a little while ago to mention the
difference
between GDP and GNP. GDP is, to me, the more natural concept. It
measures
total value-added produced by firms operating in the US. GNP, on the
other
hand, measures value-added generated by factor inputs, capital and
labor,
owned by Americans. This is slightly different because there are
foreign
factors (labor and capital) producing in the US and American factors
producing
abroad. Here's a concrete example. An American working in London for
Goldman Sachs would count in US GNP but not US GDP. She would also
count in
British GDP, since she's working there.
To clarify the distinction between GDP and GDP take
the following example. Suppose that the firm we considered before is
partly
owned by Japanese owners. Let us also assume that some of the workers
in
the firm are Japanese managers temporarily working in the U.S. Then:

Sales revenue 40,000,000

Expenses 26,000,000

Wages 20,000,000 Paid to US workers 18,000,000 Paid to Japanese managers 2,000,000 Cost of Parts 6,000,000

Net Income 14,000,000 Paid to American owners 9,000,000 Paid to Japanese owners 5,000,000

In this example:

GDP = 34m = 40m - 6m = 20m + 14m

GNP = GDP - 2m - 5m = 27m = 18m + 9m

GNP = GDP - factors payments to foreigners (dividends, interest,
rent
to foreign residents owning assets in the US and wages of foreign
residents
working in the US) + factor payments from abroad to US residents
(dividends,
interest, rent to US residents owning assets abroad and wages of
Americans
working abroad).
The difference
between GDP and GNP is not very large in the U.S but can be very
large
for countries such as Mexico that have a large amount of foreign debt
on
which they pay interest to foreigners and countries such as Ireland
where
a large fraction of the factories are owned by foreign multinationals
that
receive profits and royalties on their Irish operations.

Given the above identity, it is easy to see that GNP will be greater
(smaller) than GDP if the country is a net creditor (net debtor).

Some examples of the national accounts at work:

1. GDP at factor cost. You'll note in the PC example that we could
calculate
value-added in two equivalent ways. We can take sales and subtract
costs
of raw materials: 40m - 6m = 34m. Or we could add up the profits and
payments
to labor: 20m + 14m = 34m. Double-entry bookkeeping always allows you
multiple
ways of deriving any number. Both of these methods are used in
constructing
the national accounts in the US. When there are capital costs these are
counted, too, as part of value-added and GDP (next section).

2. Government services. Here there is no figure analogous to sales
(unless
you think of taxes this way). In the national accounts, value-added is
generally computed by adding together payments to labor and (sometimes)
capital. For example, payments to Commerce Department employees count
as
value-added in government services.

3. Imported oil. Suppose that the US economy continues to produce
the
same quantities of output at the same prices after an increase in the
price
of oil. The value of this output is, by assumption, the same after oil
prices rise, but with more of this value going to oil producers a
smaller
share is left for domestic factors, capital and labor. The price
increase
thus leads to a decline in value-added. [Think of the PC assembler: if
the cost of parts rises to 8m, what happens to value-added if other
costs
and revenues stay the same?]

4. Underground economy. By practical necessity only market activity
is measured. The old example, not especially relevant these days, is
that
maids count in GDP but housewives do not. There's some question about
the
entire underground economy, which by its nature is hard to monitor and
does not show up in GDP or GNP. In a curious example, economists
recently
estimated that Italy had a GDP as large as the UK once they included an
estimate of its underground economy.

5. Clean air. There is no market transaction for clean air and
pollution,
so this aspect of our quality of life is not incorporated in GDP. GDP
is
not, then, a catchall measure of our well-being. What does show up in
GDP
is expenditures on pollution control equipment. [Perhaps the EPA's plan
to allow firms to trade pollution rights in open markets will change
this.]

Accounting Identities

By the magic of double entry bookkeeping, we can divide GDP up in a
number
of ways. This will give us several identities that will reappear in
different
guises throughout the course.

The first is to think of value-added as payments to labor and
capital.
The point is that sales revenue shows up as income to someone.
Intermediate
goods are income to the firm that makes them, wages are income to
workers,
and profits are income to the people who own the firm. As a result, we
can think of GDP as measuring either income or output: the two numbers
are the same thing.

Let's go back to our PC assembler to see this in action, adding a
few
things to make it more realistic.

Thus we can divide value-added (34m) into payments to labor (20m) and
payments
to capital (14m=2m+4m+8m). Since we are including depreciation in our
measure
of output, we refer to it as gross output---gross of depreciation.
That's
why we call our output number GDP---G for gross. Net Domestic Product
(NDP)
is GDP minus depreciation:

Net Domestic Product = GDP - Depreciation = 34m - 4m = 30m

The reason we tend to stick with GDP is that economic depreciation
(as
opposed to what shows up on financial statements and tax returns) is
difficult
to measure.

The national income and product accounts do this at the aggregate
level,
with a couple added complications. The numbers in 1994 looked like this
(in billions of dollars):

1. National Income 5,495.1

2. Compensation of employees 4,008.3

3. Proprietor's income 450.9

4. Corporate Profits 526.2

5. Rents 116.6

6. Net Interest 392.8

This is basically the same thing we did for the firm. Line 2 is labor
expenses,
lines 4 are corporate profits, line 3 is a combination (for
unincorporated
businesses, like farmers and doctors, it's not easy to separate labor
and
capital expenses). On average, about 60-70 percent of gross output goes
to labor, the rest to capital (including corporate profits, rents, net
interest and proprietor's income). The point is that GDP measures both
production of goods and services and income to workers and owners: by
the
logic of double entry bookkeeping, the two are inseparable.

Our second look at GDP comes from the perspective of purchases of
final
goods: who buys them (consumers, firms, governments, or foreigners).
The
most common decomposition of this sort is

Net
exports is simply exports (X) minus imports (M) or NX = X
- M. Net exports are also referred to as the trade balance. Consumption
is expenditures on consumer goods by households. Investment
in this course will always mean accumulation of physical capital:
purchases
of new buildings and machines, plant and equipment in the language of
national
income accountants (a close relative of the beloved PPE of financial
accounting).
It also includes accumulation
of inventories
(that is, the change in stocks of inventories). Government
consumption here consists of purchases of goods and services
(mainly
wages) and does not include government outlays for social security,
unemployment
insurance, or interest on the debt. We think of these, instead, as
transfers,
since no goods or services are involved. We'll see more of this when we
look at the government deficit. U.S. data on the various components of
GDP are contained in Tables
published in the Economic Report of the President. The data for
1994
are as follows:

This gives us the same number for GDP as our previous method of summing
value-added across firms. Although purchases of domestic intermediate
goods
(steering wheels) do not show up explicitly, they are incorporated in
the
value of final goods (cars). For firms as a group, domestically
produced
intermediate goods net out: a sale by the steering wheel company, an
equivalent
purchase by the car company. Purchases of foreign intermediate goods
show
up as imports.

Given the definition of net exports as X-M, we can also rewrite the
national income identity as:

GDP + M = C + I + G + X

The left hand side of the expression represents the total supply of
goods available in the country; such a supply is the sum domestic
supply
(GDP or domestically produced goods) and foreign supply of goods
(imports).
The right hand side says that the total supply of goods is purchased
either
by private consumers (C), firms for investment purposes (I), the
government
for its own public consumption (G) or foreign agents in the form of
exports
(X).

The Current Account

We will now define a very important concept, the current
account
of the balance of payments, that is quite related to the trade balance
(net exports, NX).

Given the definition of GNP, we also get:

GNPt = GDPt + it
NFAt = Ct + It + Gt + (NXt
+ it NFAt ) =

= Ct + It + Gt +
CAt

where:

CAt= NXt+
it
NFAt

Current Account = Trade Balance + Net Factor
Income
from abroad

The subscript t refers to a period t variable. If we take data ar a
yearly frequency, GNPt would be GNP in year t, say 1997. The
difference between the trade balance and the CA can be very large if a
country is a large creditor or debtor.

Example: Brazil in 1986.

NX = + $ 8.3bCA = - $ 5.3bi NFA = -$ 13.6b

In this example, Brazil had in 1986 a large current account deficit
in spite of a trade surplus. In fact, Brazil was a heavy foreign
debtor,
having borrowed a lot in the 1970s and 1980s. By 1986 the total foreign
debt of Brazil was above $100b and the net foreign interest payments on
that debt (and profit repatriations of foreign firms owning assets in
Brazil)
equaled $13.6b.

As the table below shows, in Asia large current account deficits (as
a share of the country GDP) were prevalent in the 1990s. They resulted
from very large trade deficits (NX<0) and, in some countries, large
interest payments on foreign debt (i NFA <0) ; such
large
current account imblances eventually led to the currency and debt
crisis
of 1997.

To understand better why a country may be running a current account
deficit or surplus, one should notice that the current account is the
difference
between what a country produces (GNP) and what the country spends
(total
consumption plus investment). In fact:

CA = GNP - (C + G + I)

where GNP is income and (C +G +I) is domestic spending for
consumption
and investment purposes (formally called "absorption"). If a country
produces
more than it spends, the excess of goods produced over those bought at
home for consumption and investment purposes must be on net exported to
the rest of the world (a positive external balance). So, if GNP >
Absorption,
the external balance is positive or, equivalently, the current account
is in surplus. Viceversa, if If a country produces less than it spends,
the excess demand of goods for consumption and investment purposes over
income/production must be on net imported from the rest of the
world
(a negative external balance). So, if GNP < Absorption, the external
balance is negative or, equivalently, the current account is in
deficit.

Another way to understand the current account is to see that it is
the
difference between national savings and national investment. In fact,
as
for an individual, we can define savings as the difference between
income
and spending for consumption purposes. If I consume more (less) than my
income my savings are negative (positive). In the case of a country
consumption
is made both by the private (C) and public sector (G). So, by
definition,
national savings are equal to:

S = GNP - C - G

Substituting this definition of savings in the expression for the
current
account, we get:

CA = S - I

To see why the current account is equal to the difference between
savings
and investment, consider the similarity of a country with an
individual.
For simplicity, suppose initially that the investment of the individual
is zero and that G=0. If an individual consumes (C) more than his/her
income
(GNP), the savings (S=GNP-C) of the individual will be negative
(S<0).
Since the individual investment is zero, the current account of the
individual
will be equal to his/her savings (CA=S<0). So, an individual with
negative
savings has a deficit in its current account. In a similar way, if I=0,
a country running a current account deficit is consuming (including
both
public and private consumption) more than it is producing as CA = S =
GNP-C-G.

Consider now how positive investment (I>0) changes things. Take
again
the case of an individual who has now positive savings (S=GNP-C >0).
Suppose
now that the individual makes real investments; for example, he/she may
buy a new home (residential investment). Suppose that the investment in
the new home is greater than the savings of the individual (I > S)
as it
is usually the case. In this case the current account of the individual
is in deficit as CA = S - I <0. Since the income of the individual
(GNP)
is less than his/her total spending (for consumption and investment),
the
individual current account is in deficit, or the individual's savings
are
below the individual's investment. The same story holds for a
country.
If a country invests more than its saves, the country is
producing
an amount of output/income (GNP) that smaller than the total spending
on
goods for consumption and investment purposes (C+G+I). Therefore, the
excess
of spending (absorption) over income or, equivalently, the excess of
investment
over savings implies that the country is running a current account
deficit.

Insight in the Asian economic crisis: Why current
account deficits lead to the accumulation of a large stock of foreign
debt.

It is very important to understand that if a country runs a
current
account deficit (CA<0), as it is the case in many developing
countries
such as those currently in crisis in Asia , this means that the country
is borrowing from the rest of the world and its foreign debt will
increase
over time. Thus, flows (items on income and cash flow statements)
translate
into changes in stocks (balance sheet items, like household wealth, the
stock of capital, government debt, and net foreign debt).

To understand this important point, we need to be more specific
about
the distinction between stocks and flows. A stock is measured at a
particular
point in time such as the stock of capital at the end of 1997. A flow
instead
represents the change in the stock over a particular period of time:
for
example net investment in capital in the year 1997 is equal to the
difference
between the stock of capital between the end of 1997 and the end of
1996.
So, if we define with K the stock of physical capital, this stock is
related
to the flow of net investment (I - depreciation) by:

Kt+1 = Kt+ It -
Depreciationt

or:

Stock of K at time t+1 = Stock of K at time t + (Net Investment in
new
capital in period t)

Then, the flow of new investment is equal to the change in the stock
of capital

It - Depreciationt = Kt+1
- Kt

Note that macroeconomists typically measure K at replacement cost
rather
than book value.

Similarly, the current account in the year 1997 is equal to the
difference
in the stock of net foreign assets of the country between the end of
1997
and the end of 1996. A current account surplus results in an increase
in
the net foreign assets of a country while a current account deficit
results
in a decrease of these assets or, if the country is already a net
debtor,
it results in an increase in the net foreign debt of the country.

To understand why a current account deficit leads
to an increase in the stock of foreign debt of a country, consider the
similarity of a country with the budget constraint of an
individual.
For simplicity, suppose initially that the investment of the individual
is zero (I=0). If an individual consumes (C) more than his/her income
(GNP),
the savings (S=GNP-C) of the individual will be negative (S<0).
Since
the individual investment is zero, the current account of the
individual
will be equal to his/her savings (CA=S<0). So, an individual with
negative
savings has a deficit in its current account. If the individual has an
initial positive wealth (NFA=(Assets-Liabilities)>0), then these
negative
savings (current account deficit) will lead to a fall of his/her
net wealth (assets minus liabilities) as he/she will run down his/her
assets
or, for given gross assets, he/she will borrow to pay for the excess of
the consumption over income. In either case (regardless whether gross
assets
are run down or new gross borrowing are made) his/her net wealth will
fall
as personal assets fall and/or personal debt goes up. If savings
are negative year after year, at some point net assets will fall to
zero
and the individual will become a net debtor (assets-liabilities <
0).
In this case negative savings will lead over time to a growing net debt
of the individual.
In a similar way, if I=0, a country running a
current
account deficit is consuming (including both public and private
consumption)
more than it is producing as CA = S = GNP - C- G. Therefore, to
finance
such a deficit the country needs to run down its assets and/or borrow
to
pay for the excess of consumption (C+G) over income/output (GNP). In
either
case (regardless whether gross assets are run down or new gross foreign
borrowing are made) the country's net foreign wealth (NFA = Foreign
Assets
- Foreign Liabilities) will fall as foreign assets fall and/or
foreign
debt goes up. If the country is initially a net creditor (NFA>0),
over
time current account deficits will lead the country to become a net
debtor
(NFA<0) as net assets fall and eventually become negative; to
finance
the deficit, each year the country will borrow from the rest of the
world
an amount of funds that is equal to the excess of income over
consumption.
So the new borrowing (the increase in foreign debt) is equal each
year to the current account deficit. So, if a country is already a net
debtor, further current account deficits will lead this country to
increase
its stock of net foreign debt.
Consider now how investment changes things. Take
again the case of an individual who has now positive savings (S=GNP-C
>0).
Suppose now that the individual makes real investments; for example, he
may buy a new home (residential investment). Suppose that the
investment
in the new home is greater than the savings of the individual (I >
S) as
it is usually the case. In this case the current account of the
individual
is in deficit as CA = S - I <0. To finance the excess of
his/her
investment over savings, the individual can do two things: either run
down
his/her financial assets (if there are enough assets to be run down)
and/or
borrow to finance the new investment. In either case, the excess of I
over
S leads to a reduction of the net assets (assets-liabilities) of the
individual.
If such current account deficits occur over time net assets will fall
to
zero and the individual will become a net debtor; the increase in stock
of debt will be each year equal to the current account deficit.
The same holds for a country that has a current
account deficit. If a country invests more than its saves, it has to
borrow
from the rest of the world to finance this deficit. In fact, a CA
deficit
means that the country is producing an amount of output/income (GNP)
that
falls short of the total spending on the goods of the country ( the sum
of consumption and investment):

CA = GNP - C - G - I

To finance the excess of investment over savings, the country can do
two things: either run down its financial foreign assets (if there are
enough foreign assets to be run down) and/or borrow from the rest of
the
world to finance the new investment. In either case, the excess of I
over
S leads to a reduction of the net foreign assets (foreign assets -
foreign
liabilities) of the individual. If such current account deficits
continue
year after year net foreign assets will fall to zero and the country
will
become a net debtor; in each year the increase in stock of foreign debt
will be equal to the current account deficit. More formally, the change
in the net foreign asset of a country (a change in stocks) will
therefore
be equal to the current account (a flow) or:

NFAt+1 - NFAt = CAt

If CA>0 net foreign assets will increase (or net foreign debt
will become
smaller if the country was starting with net foreign debt, NFA<0);
if
CA<0 net foreign assets will decrease (or net foreign debt will
become
bigger if the country was starting with net foreign debt, NFA<0). In
each period net foreign borrowing will be equal to the current account
deficit (or net accumulation of foreign assets will be equal to the
current
account surplus).

Another way to see that the previous equation holds is to notice
that
the net foreign assets at the beginning of next period (t+1) must be
equal
to those in period t plus total national income (GNP) minus the part of
national income that is consumed (C and G) or invested (I):

NFAt+1 = NFAt + GDPt
+ it NFAt - Ct - Gt
- It = NFAt + CAt

Therefore:

NFAt+1 = NFAt + CAt
= NFAt + NXt + it NFAt

We refer to NFAt as the initial balance and NFAt+1
as the ending balance.

The above discussion clarifies why some countries have a very large
stock of foreign debt: like in the case of an individual, if you
consume and invest more than you produce (earn income) year after year,
you must borrow over time to finance this current account deficit
(excess
of consumption and investment over income or excess of investment over
savings). Therefore, your individual's or country's net foreign debt
must
increase over time. So countries with a large stock of foreign debt
have
had in the past large current account deficits that have led to an
accumulation
of this debt. This is very important to understand what happened in
Asia
in 1997. During the 1990s, all the Asian "crisis countries" run very
large
and increasing current account deficits as their national income (GNP)
was below their domestic absorption (C+G+I) (or as their investment
rates
I were above their savings rates); this led to a large accumulation of
foreign debt that eventually became unsustainable.

What Causes Current Account Deficits? Are Such
Deficits
Bad?

Now that we have understood the meaning of the current account and
how
it relates to the foreign debt of the country, we want to analyze in
more
detail the link between the current account, private savings and
government
budget deficits. This will help us to understand whether current
account
deficits are caused by budget deficits (the "twin deficits"
hypothesis).

We take our earlier national income account identity (GNP = C
+ I + G + CA) and do a little algebra to get:

(GNPt -Tt -Ct )
=
It + (Gt -Tt ) + CAt ,

where

GNPt - Tt - Ct =
Stp=
Private Savings

and Tt are taxes collected by the government (TXt
) net of transfer payments (TRt ) and interest payments on
the
public debt (it Debtt ). So:

Tt = TXt - TR t
-
it
Debtt .

T is intended to measure all revenues and expenses of the government
not included in G, so G-T is the government deficit, NIPA version, a
close
relative of the number bandied about in the business press. It's only a
relative because (i) the press generally focuses only on the federal
government
and (ii) the Administration and Congress typically have more
imaginative
measures of the deficit. Note the sign convention: unlike what you
generally
do in accounting, a deficit is a positive value of G-T. Continuing with
the identity: GNP-T measures the amount of income households have on
hand
once we take into account things like taxes paid to the government,
social
security payments, and interest on the government debt. GNP-T-C is thus
the amount of income households do not spend on goods and services,
namely
private saving Sp. Conversely, we can define public
(government
savings) Sg as the difference between government revenues
and
spending. So:

Deft = (Gt - Tt
)
= Gt - TXt + TRt + it
Debtt = - Stg

or

Stg = - Deft = Tt
- Gt

Thus we can write the identity

Stp = It+
Deft+ CAt
(1)

where Def = G-T is the government deficit as measured by the NIPA.
This
connects private saving, investment, the government deficit (negative
public
savings) and the trade balance. Sometimes we combine S and Def, as in

St= Stp
- Deft= Stp+
Stg = It+
CAt

or

St = It + CAt(2)

that implies our earlier definition of the current account:

CAt= St- It(3)

where S is a comprehensive measure of national savings, the sum of
private
and public savings or, if the government is running a deficit, it is
total
savings net of government dissavings.

The first identity (1), which is based on flows of goods, suggests
our
earlier interpretation of how current accounts lead to a change in the
stock of assets. Private savings, under this interpretation, are a
source
of new financial capital, since saving leads to purchases of assets.
Savers
can purchase either corporate securities (which finance new investment
by firms in plant and equipment, I), government securities (which go to
finance the government deficit, Def), or foreign securities (which
finance
a current account surplus if CA is positive); the latter purchase of
foreign
assets leads to an accumulation of net foreign assets. If the CA is
negative,
this means that private savings are not enough to finance both
investment
and the budget deficit; therefore foreign savings (borrowing from the
rest
of the world in the form of an accumulation of foreign debt) is
required
to finance the excess demand of funds by firms (for investment) or
government
(for deficit financing purposes) relative to the quantity of private
savings
. This also tells us, for example, that the government and private
industry
may be competitors in capital markets for the pool of private savings:
if the government takes more, there is less to support private
investment.
The second identity expresses national savings (S) as equal to national
investment (I) plus the current account (CA). The third identity
expresses
the current account (CA) as the difference between national savings (S)
and national investment (I).

There are a couple of connections here that get one thinking about
the
operation of the economy. One is the connection between the government
deficit (Def = G-T) and the current account deficit (-CA ). A
government
deficit must be matched by some combination of higher saving, lower
investment,
or a trade deficit. To the extent it's the latter, a large government
deficit
will be associated with a large trade (current account) deficit. One of
the questions we want to keep in mind for the future is whether the
trade
deficit is largely the result of the government deficit, rather than
more
fundamental problems with US competitiveness. Another issue is the
relation
between saving and growth. Two of the things we know are (i) countries
that save a lot are also countries that invest a lot and (ii) countries
that invest a lot grow faster. We'll return to (ii) in a week or two.
For
now, let me say simply it's not clear what the direction of causality
here:
whether higher investment leads countries to grow faster, or countries
that grow fast for other reasons (technology?) invest a lot. It's
clear,
though, that growth and investment are closely related in the data. As
for (i), I've computed ratios of S, I, and CA to real GNP (defined with
the variable Y) for a number of major countries, and reported them in
Table
1. The definition of saving is here total national savings

S = Y - C - G

We then have the identity S = I + CA . You see in Table
1 that the US saves and invests much less, as a fraction of
national
output, than most other developed countries. Japan, on the other hand,
saves and invests substantially more. You might plot the growth rates
vs
saving and investment rates to see how they are related.

Finally, note that, given our definition of budget deficits, and our
previous discussion of how flows lead to changes in stocks, we can show
that a government deficit results in an increase in the stock of
government
debt or:

Debtt+1 = Debtt+ Gt
- Tt = Debtt+ (Gt + TRt
- TXt) + it Debtt

We refer to Debtt as the beginning balance and Debtt+1
as the ending balance.

Another detail. You might be asking yourself (if not, don't) why all
taxes are paid by households: what about the corporate income tax? The
answer is that firms are owned (for the most part) by households and we
are consolidating their books. We attribute to households all the
before-tax
profits of firms (in value added). We then have them pay the firms'
taxes.
This is equivalent to just giving them after-tax profits in the first
place.
The only fudging arises with firms not owned by Americans. In the real
accounts the rest of the world (i.e., foreigners) can own some US
firms,
pay taxes, collect interest on US government debt, and so on, which
would
complicate the international part of the accounts. For most of this
course
we'll ignore that to make things simpler. Life is complicated enough as
it is.

Are Current Account Deficits Good or Bad? Are Large Deficits
Sustainable?

The recent experience in Asia shows that large current account
deficits
led to an accumulation of foreign debt that eventualy became
unsustainable
and led to a currency crisis. This leads to the following question: is
it a bad idea to run a current account deficit? The answer is actually
quite complex because running a current account deficit may me a good
or
bad, sustainable or not sustainable, depending on the cause of the
current
account deficit.

To specify a definition of sustainability, consider a situation
where
current macroeconomic conditions continue (i.e. there are no exogenous
shocks) and that there are no changes in macroeconomic policy. In
this instance the current account deficit can be argued to be
sustainable
as long as no external sector crisis occurs. An external sector
crisis
could come in the form of an exchange rate crisis or a foreign debt
crisis.
An exchange rate crisis could be a panic that leads to the rapid
depreciation
of the currency or a run on the central bank’s foreign exchange
reserves.
A debt crisis could be the inability to obtain further international
financing
or to meet repayments or an actual default on debt obligations. A
sustainable current account deficit is one that can be maintained
without
any of these crises occurring. Of course, sustainability can only
be judged after the fact, but we will be examining the characteristics
of the economy that are indicative of crises occurring.

If we rewrite our definition of the current account, we can see that
there are three main causes of current account deficits:

CAt = Stp
- It - Deft

A current account deficit may be caused by:

1. An increase in national investment

2. A fall in national savings; specifically:

2a. A fall in private savings and/or 2b. An increase in budget deficits (a fall in
public savings).

We want to show that a current account deficit may be bad or good
depending
on its source.

1. A boom in domestic investment.
We consider first the case where the current account deficit is caused
by a boom in investment. In this case running a current account deficit
is a good idea and the accumulation of foreign debt associated with the
deficits should not be viewed with concern. To see why, notice that a
country
is like a firm. Suppose that a firm has identified good profitable
investment
projects but that the savings of the firm (i.e. the firm's retained
earnings)
are below the value of profitable investment projects. Then, it makes
sense
for the firm to go to capital markets external to the firm and borrow
funds
equal to the difference between the value of the new investment
projects
and the firm's savings (retained earnings). This firm borrowing can
take
various forms: it could borrow funds from banks; it could issue
corporate
bonds or it could issue new equity that is purchased by agents in the
economy.
Such borrowing by the firms is optimal as long as the financed
investment
projects are profitable (i.e. as long as the return on the investment
is
as high as the cost of borrowed funds). In fact, over time, the
earnings
generated by the capital created by the new investment will be
sufficient
to pay back the principal and interest on the borrowed funds.
Now, note that a country is like a firm as in a
country thousands of firms make individual investment decisions.
Suppose
that the country experiences an investment boom. The reasons for such
investment
boom can be several: new natural resources are found in the country
(oil,
minerals); technological progress leads to new products that can be
profitably
developed and produced; structural economic reforms (like trade
liberalization
or capital market liberalization) or macroeconomic stabilization
policies
(such as a reduction in inflation, a cut in budget deficits and
reduction
in distortionary taxes on income and capital) lead to expectation of
high
future economic growth and high profitability of new investments.
In all these cases, the country will have an investment boom that has
to be financed with some savings. If the national savings of the
country
(the sum of private and public savings) are not sufficient to finance
all
new profitable investment projects, then it is optimal for the country
(like it was for a firm) to run a current account deficit, i.e.
rely
on foreign savings to finance the excess of investment over national
savings.
Such a current account deficit will imply the accumulation of new
foreign
debt, i.e. a capital inflow as foreign funds will be borrowed to
finance
domestic investment. The forms of such a capital inflow are similar to
those of a firm. First, the country (or better the country's firms)
could
directly borrow from foreign banks; second, the domestic firms could
borrow
from domestic banks but these in turn borrow from foreign banks; third,
the firm could issue new bonds that are bought by foreign investors;
fourth,
the firm can issue new equity that is purchased by foreign
investors.
Finally, if the new investment is originally made by a foreign firm
that
has decided to build a new plant in the domestic economy, the flow of
foreign
capital that finances this investment project is called Foreign Direct
Investment (FDI). In all these cases, a current account deficit (CA=
S-I
<0) is financed by some form of foreign saving (foreign capital).
And,
as in the case of a domestic firm, it is optimal for the country
to borrow funds from the rest of the world and accumulate foreign debt
as long as the new investment projects are profitable. Over time, the
goods
produced by the new capital will lead to increased country exports that
will generate the trade and current account surpluses that are
necessary
to eventually repay the foreign debt and interest on it.
So, in general a persistent current account deficit
and foreign debt accumulation generated by a boom in investment should
not be considered with too much concern and it might actually increase
the rate of growth of an economy where domestic savings are not
sufficient
to finance all profitable investment projects. There are however
several
caveats to be made to this argument.
First, borrowing form the rest of the world to
finance
investment that produces new goods is especially good if the new
investments
are in the traded sector of the economy (i.e. the sectors of the
economy
that produce goods that can be sold in foreign markets). In fact, at
some
point in time the foreign debt has to be repaid back and, for a
country,
the only way to pay back foreign debt it to run at some point trade and
current account surpluses. If the new investments are instead in the
non-traded
sector of the economy (such as commercial and residential investment),
they create goods (housing services) that cannot be sold abroad.
So, in this case the long run ability of the country to repay its debts
through trade surpluses may be limited and this can create a problem.
For
example, many Asian countries in the 1990s were running large and
increasing
current account deficits that were financing new and excessive
investments
in the non-traded real estate sector (residential and commercial
building).
Such investments went bust in 1996-97 because of a glut of real estate
and the collapse of the real estate asset price bubble that lead to a
rapid
fall in the price of land and real estate values; then, the firms
and individuals that had borrowed foreign funds (and/or the banks that
had borrowed the foreign funds and in turn lent these funds to domestic
firms and households) to finance real estate investments went all into
a financial crisis. They had borrowed too much in foreign currency to
finance
investments that had a low or negative returns. Moreover, the exchange
rate depreciation associated with this crisis made things worse as the
value in domestic currency of funds borrowed in foreign currencies
(Dollars,
Yen, Marks) increased enormously once the currencies depreciated
rapidly.
This real increase in the burden of foreign debt caused a financial
crisis
for the banks, firms and individuals heavily exposed in non-traded
sectors
(such as real estate) and led to widespread bankruptcies. So the first
caveat is that is is dangerous to run a current account deficit to
finance
excessive investments in non-traded sectors of the economy.
The second caveat is relevant both for traded sector
firms and non-traded sector firms. Every firm knows that it is optimal
to borrow funds to finance investments only as long as the return on
these
investments are at least as high as the cost of the borrowed funds;
otherwise,
a firm that borrowed too much and invested in bad projects will
eventually
experience losses, a financial crisis and potentially go bankrupt if
most
investments turn out to be bad. The story of the Asian crisis is in
part
one of a current account deficit and foreign debt accumulation caused
by
a boom of investment that turned out to be excessive. In Asia, there
were
too many investments (both in traded and non-traded sectors) that
turned
out to be not very profitable.
How can one rationally explain such overinvestment
in wrong projects? Why did the firms make such investments and borrow
the
funds? Why did the domestic banks lend them the funds and did not
monitor
the quality of the investments? To see understand this we need to
introduce
some politics and the behavior of governments. Many governments in Asia
were trying to maximize the rate of economic growth; since growth and
the
production of goods requires a lot of labor and capital, a necessary
condition
for high economic growth is a very high rate of national investment. It
appears that many governments in the region were pursuing economic
growth
targets that were excessive. Governments gave incentives (such as
subsidies)
to firms to invest too much and incentives to the domestic banks to
borrow
too much from abroad to finance dubious investment projects by the
firms.
Banks, in turn, borrowed too much from abroad
for many reasons, mostly related to the implicit promise of a
government
bail-out in case things went wrong: first, their risk capital was
usually
small and owners of banks risked relatively little if the banks went
bankrupt;
second, several banks were public or controlled indirectly by the
government
that was directing credit to politically favored firms, sectors and
investment
projects; third, depositors of the banks were offered implicit or
explicit
deposit insurance and therefore did not monitor the lending decisions
of
banks; fourth, the banks themselves were given implicit guarantees of a
government bail-out if their financial conditions went sour because of
excessive foreign borrowing; fifth, international banks (Japanese,
American
and European ones) lent vast sums of money to the domestic banks of the
Asian countries because they knew that governments would bail-out the
domestic
banks if things went wrong. The outcome of all this was twofold: first,
banks borrowed too much from abroad and lent too much to domestic
firms;
second, because of all these implicit public guarantees of bail-out,
the
interest rate at which domestic banks could borrow abroad and lend at
home
was low (relative to the riskiness of the projects being financed) so
that
domestic firms invested too much in projects that were marginal if not
outright not profitable. Once these investment projects turned out not
to be profitable, the firms (and the banks that lent them large sum)
found
themselves with a huge amount of foreign debt (mostly in foreign
currencies)
that could not be repaid. The exchange rate crisis that ensued made
things
only worse as the currency depreciation dramatically increased real
burden
in domestic currencies of the debt that was denominated in foreign
currencies.

2. A current account deficit caused by a fall in national
savings:
a fall in private savings or an increase in budget deficits (a
fall
in public savings).

Apart form the previous case of an investment boom, a current
account
deficits may also be caused by a fall in national savings. A current
account
imbalance caused by a fall in the national savings rates can be due to
either a fall in private savings or in public savings (higher budget
deficits).
A fall in national savings caused by lower public savings (higher
budget
deficit) is potentially more dangerous than a fall in private savings.
The reason for this is that a fall in private savings is more likely to
be a transitory phenomenon while structural public sector deficits are
often hard to get rid of. The private savings rate will recover
when
future income increases occur. On the other hand, large and persistent
structural budget deficits may result in an unsustainable build-up of
foreign
debt. For example, in the late 1970s many developing countries were
running
very large budget deficits to finance large and growing government
spending;
to finance these deficits, the governments borrowed heavily in the
world
capital markets (either directly from international banks or indirectly
by issuing bonds purchased by foreign investors). In this case, the
large
and growing budget deficits led to large current account deficits and
the
accumulation of a very large stock of foreign debt. By 1982, the size
of
this public foreign debt was so large (often close to or above 100% of
GDP) that many governments began having difficulties in repaying
interest
and/or principal on their foreign liabilities; therefore, a severe Debt
Crisis emerged in the 1980s with many countries risking default
on
their foreign debt and having to negotiate a rescheduling of their
foreign
liabilities. So the lesson is that running current account deficits and
borrowing from abroad to finance budget deficits is a dangerous game
that
will eventually lead to a debt crisis. Unlike firms that borrow to
finance
investment projects that will be eventually self-financing (as they
generate
trade surpluses that will be used to repay the original foreign debt),
fiscal deficits are rarely self-financing, especially if such deficits
are chronic, the result of excessive spending and structural lack of
tax
revenues.

Unlike the case of a current account caused by a fall in public
savings
(a larger budget deficit), a current account caused by a fall in
private
savings is usually considered with less concern. A fall in private
savings
rate may be transitory and occur when expectations of higher future GDP
growth result in an increase in current consumption above current
income.
For example, an MBA student in school will usually have zero or close
to
zero income in the two years he/she is in school. Since consumption is
positive while in school (you got to eat and cloth to live!), the
student
has negative savings (S=GNP-C < 0 as GNP=0 and C>0) and a current
account
deficit. [Note also that the student is borrowing money not only
to finance its negative savings but also to finance its MBA tuition:
this
is an Investment in human capital that will eventually lead to higher
income;
so it is also optimal to borrow to finance that tuition investment]. In
this case, negative savings lead to a current account deficit and
accumulation
of personal debt; however, this borrowing is optimal since the student
is consuming today not on the basis of his/her current low income but
on
the basis of its permanent income that is high because of the expected
higher income after school. So, this transitory fall in savings and
accumulation
of debt is optimal since the higher income after school will be above
consumption
and lead to the repayment of the debt incurred while in school. The
same
happens for a country: an economic reform or stabilization may lead to
a consumption boom (especially purchases of durable goods) even if
current
incomes have not increased yet so much because households in the
economy
expect high future incomes because of the expectations of future high
economic
growth. In this case, current consumption (C) goes up a lot today while
income (GNP) grows only over time; this consumption boom leads to a
fall
in private savings; the ensuing current account deficit is financed (at
the aggregate country level) through an inflow of capital from abroad.
This accumulation of foreign debt is not worrisome as long as future
income
growth is realized and individuals are able to repay their debts
(foreign
liabilities).

Needless to say, many episodes of unsustainable current account
deficits
do not fit the patterns described. For example, the deterioration
of the current account balance in the years preceding the 1994 Mexican
peso crisis was largely due to a fall in private savings. In the
Mexican
episode, the boom in private consumption and the sharp fall in private
savings rates was fueled by the combined forces of overly optimistic
expectations
about future growth and permanent income increase together with the
loosening
of liquidity constraints on consumption deriving from the
liberalization
of domestic capital markets. Under such conditions, the fall in private
savings rates led to a rapid and eventually unsustainable current
account
deterioration. Moreover, while the 1980s foreign debt crisis was caused
by very large budget deficits, more recent episodes of debt crisis do
not
seem to have their source in a fiscal imbalance. For example, the
1990-94 Mexican episode and the 1997 Asian crises occurred in spite of
the fact that the fiscal balances were in surplus; the large and
increasing
current account deficits and foreign debt accumulation were caused by
the
private sector behavior, a fall in private savings and an increase in
investment.
This suggests that current account deficits that are driven by
structurally
low and falling private sector saving rates may be a matter of concern
even if they are the results of the "optimal" consumption and savings
decisions
of private agents. This is especially the case when the private
consumption
boom, like in Asia in the 1990s, is in part the consequence of an
excessively
rapid liberalization of domestic financial markets that gives access to
credit to households that were previously borrowing-constrained.

Whether a large current account deficit is sustainable or not also
depends
on a number of other macroeconomic factors: 1. the country's growth
rate;
2. the composition of the current account deficit; 3. the degree of
openess
of the economy (as measured by the ratio of exports to GDP); 4. the
size
of the current account deficit (relative to GDP).

1. Large current account deficits may be more sustainable if
economic
growth is higher. High GDP growth tends to lead to higher investment
rates
as expected profitability increases. At the same time, high
growth might lead to higher expected future income and (as noted above)
transitory declines in private savings rates. Generally, higher growth
rates are related to more sustainability of the current account deficit
because, everything else equal, higher growth will lead to a smaller
increase
in the foreign debt to GDP ratio and make the country more able to
service
its external debt. However,, many episodes of unsustainable current
account
deficits do not fit the patterns described. In particular, the
examples
of Chile in 1979-81, Mexico in 1977-81 and the Asian countries in 1997
come to mind. In all these instances the average real GDP growth
rate in the years preceding the crisis was above 7%: what happened was
that excessively optimistic expectations that the high economic growth
would persist for the long-term led to an excessive investment boom and
a boom in private consumption (a fall in private savings) that resulted
in current account deficits and growth of foreign debt; the latter
eventually
became unsustainable and caused a currency and debt crisis (as in Asia
in 1997-98).

2. The composition of the current account balance which is
approximately
equal to the sum of the trade balance and the net factor income from
abroad
will affect the sustainability of any given imbalance. A current
account imbalance may be less sustainable if it is derived from a large
trade deficit rather than a large negative net factor income from
abroad
component. In fact, for a given current account deficit, large and
persistent
trade deficits may indicate structural competitiveness problems while
large
and negative net foreign factor incomes may be the historical remnant
of
foreign debt incurred in the past.

3. Since a country's ability to service its external debt in the
future
depends on its ability to generate foreign currency receipts, the size
of its exports as a share of GDP (the country's openness) is another
important
indicator of sustainability.

4. Most episodes of unsustainable current account imbalances that
have
led to a crisis have occurred when the current account deficit was
large
relative to GDP. Lawrence Summers, the U.S. deputy Treasury
secretary,
wrote in The Economist on the anniversary of the Mexican financial
crisis
(Dec. 23, 1995-Jan. 5, 1996, pp. 46-48) “that close attention
should
be paid to any current-account deficit in excess of 5% of GDP,
particularly
if it is financed in a way that could lead to rapid reversals.”
By
this standard, many of the Asian economies provided ample source for
concern
in the 1990s as they had very large and increasing deficits, well above
the 5% red flag.

The above analysis suggest that there is not anything inherently
good
or bad about a current account deficit. Like and individual or a firm
that
borrows funds, a country may be borrowing funds from the rest of the
world
for good or bad reasons. So a current account deficit and the ensuing
accumulation
of foreign debt may be good, sustainable and lead to higher long-run
growth
or may be eventually unsustainable and lead to a currency and debt
crisis
depending on what drives the current account deficit. We will return to
the discussion of current account and foreign debt sustainability in Chapter
3.

Prices and Real Quantities

One of the things you may have noticed is that the national accounts
have
been measured, so far, in dollars. The problem (unlike physics, where,
generally, a meter is a meter and a second is a second) is that the
value
of a dollar isn't constant. Sometimes a dollar buys a lot of goods,
sometimes
not so many. It seems ridiculous to argue that GDP in Brazil in the
early
1990s was rising at more than 1000 percent a year, when almost all of
that
increase reflects increases in cruzeiro (the local currency) prices of
goods, not increases in quantities of the goods produced. This issue is
not simply an academic one; it shows up as well in accounting standards
for foreign subsidiaries of US companies operating in high-inflation
countries,
who are generally required to translate profits of subsidiaries into US
dollars (or other more stable currency).

As a result, a great deal of effort goes into measuring "real'' (as
opposed to "money'' or "nominal'') GDP and related quantities and
constructing
indexes of "average'' dollar prices. For GDP we would generally like to
compare quantities of output produced in different periods, so that an
increase in GDP means we are producing more of something.

How to measure correctly the real value of GDP and the correct level
of the inflation rate is a difficult issue. Until the end of 1995, the
U.S. followed a "fixed-weight" approach to the measurement of real GDP
but has since moved to a "chain-weight" method. This move was. however,
somewhat controversial and object of a serious debate. For what
concerns
the inflation rate, we can measure it by using the price deflator
series
derived from the calculation of real and nominal GDP or we can measure
it by calculating the CPI (Consumer Price Index) inflation rate.
Recently,
however, it has been argues that the CPI inflation rate overstates the
true inflation rate. In December 1996, the Boskin
Commission appointed by the Senate Finance Committee, reached the
conclusion
that the CPI overstates the annual inflation rate by 1% to 2% per year.
To understand these recent
debates on the correct measurement of GDP and inflation, we need to
consider in more detail these issue. In particular, we need to start by
understanding why the US switched from a fixed-weight to a chain-weight
method to measure real GDP and why the CPI inflation rate might be
overestimated.
Let us start with the fixed-weight GDP measure.

Suppose, for example, we want to compare GDP in 1993 to GDP in 1992.
The (fixed-weight) measures of nominal and real GDP using 1987 as the
base
year (the method used until the end of 1995) were:

Nominal GDP

Real GDP

1987

4539.9

4539.9

1992

6020.2

4979.3

1993

6343.3

5134.5

The growth rate of nominal GDP in 1993 was:

5.3% = 100 x (6343.3 - 6020.2)/6020.2

But how much of that reflects a decline in the value of the dollar?
What we might do is measure the 1992 and 1993 quantities and value them
at the same prices to get a "constant'' price comparison. The NIPA, for
example, used to measure everything in 1987 prices; 1987 is referred to
as the base year. This was a "fixed-weight" method since it implied
measuring
quantities of goods in different years at the prices prevailing in a
base
year. Using this method, GDP in 1987 prices was 4979.3 in 1992 and
5134.5
in 1993, implying a grow rate of real GDP of

3.1% = 100 x (5134.5 - 4979.3)/4979.3

Thus it appears that 2.2 percent (5.3% - 3.1%) of the growth in
current
dollar GDP was simply a general increase in dollar prices of goods.

This general increase in prices is implicit in the real and nominal
measures of GDP. One measure of the average price is the ratio of GDP
in
current prices to GDP in 1987 prices. We call this measure of prices
the
GDP implicit price deflator:

Since yp is a small number, the expression (*) is approximately
equal
to:

nyt = yt + pt

Or:

(NYt - NYt-1)/NYt-1
= (Yt - Yt-1)/Yt-1 + (Pt -
Pt-1)/Pt-1.

Figure 6 shows the levels of nominal and real GDP
for the U.S. economy; note that since the base year for the comparison
is 1992, nominal and real GDP are equal to each other in that year as
the
deflator is equal to 1 by choice of the base period. Figure
7 presents a graph of the rate of growth of nominal and real GDP
for
the U.S. economy. As inflation is positive, nominal GDP growth is above
real GDP growth.

This is simply one example of a price measure. There are also price
deflators for components of GDP: consumption, investment, government
spending,
exports and imports. The most common measure of price movements,
though,
has nothing to do with the national income accounts.

The Consumer
Price Index measures the dollar price of a "fixed basket'' of goods
rather than the constant price of a changing basket of goods used to
compute
the "fixed-weight" GDP and its nominal price deflator.

The idea is to calculate the price of a constant list of goods at
different
points in time. Eg, consider 5 gallons of gas, one haircut, 2 pounds of
chicken, 3 bottles of soda, and so on. The Bureau of Labor Statistics
at
the Department of Labor sends people to stores every month to collect
prices
of the various goods, and then computes prices of various "baskets.''
The
Consumer
Price Index (CPI) is the total price of all of these goods at
different dates, normalized to equal 100 at some date. Same idea,
really,
as the Dow Jones Industrial Average or the S&P 500. The CPI takes
its
basket of goods from the typical spending patterns of an American
family.

The conceptual problem for both price indexes---the fixed-weight GDP
deflator and the fixed basket CPI deflator ---is that it's not clear
how
to measure the purchasing power of the dollar when the dollar prices of
different goods are changing at different rates. Conversely, it's not
clear
how to combine quantities of different goods when their relative prices
are changing. As usual, this is easier to see with an example.

Example (made-up numbers).

Our economy produces two goods, fish and and chips (computer chips,
not potato ones). At date 1 we produce ten fish and and ten chips. Fish
cost 0.25 cents and chips 50 cents. At date 2 the price of fish has
risen
to 50 cents and of chips to 75 cents and the quantities have changed to
8 and 12.

Price of Chips

Quantity of Chips

Price of Fish

Quantity of Fish

Date 1

0.5

10

0.25

10

Date 2

0.75

12

0.50

8

Note that the two prices have not gone up by the same amount: fish
inflation
is 100 percent but chip inflation is 50 percent. Another way to say the
same thing is that the relative price of chips to fish has fallen from
2 (=.50/.25) to 1.5 (=.75/.50). What is the change in the price level?

Example continued (fixed-weight GDP deflator and fixed-weight
real GDP). We construct GDP at both dates in current prices and
in date 1 prices.

Date 1 Nominal GDP = $7.50 (= .50x10 + .25x10)

At date 2

Date 2 Nominal GDP = 13.00 (= .75x12 + .50x8).

In date 1 prices ("real'') GDP is:

Date 1 prices ("real'') GDP = 8.00 (= .50x12 + .25x8).

The GDP deflator (the ratio of current price GDP to GDP in base year
prices, here date 1) rises from 1.0 in the base year date 1 to 1.625 (=
13/8) at date 2, an inflation rate of 62.5 percent.

The the, real GDP growth measured with fixed weights is:

6.66% = 100 x (8-7.5)/7.5

In fact, since we know from (*) above that::

(1 + ny) = ( 1 + y) x (1 + p)

real growth y is:

y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.625)] -1 = 0.066

Consider now what happens to our measure of real GDP growth when we
use a "fixed-basket" based measure of inflation (the CPI index).

Example continued ("fixed-basket" CPI
deflatorand real GDP). The consumer price index
uses
quantities in a base year to compute the costs of the same basket of
goods
at 2 different dates. Let's say here that the basket of goods is 10
fish
and 10 chips (the same composition as GDP). Then:

Note the difference between the two indexes: the CPI uses date 1
quantities
while the GDP deflator uses date 2 quantities to compute the date 2
price
index. (Check out the CPI
Calculation Machine at the Minneapolis Fed home page to get, say,
the
price of a cup of coffee in 1963).

Since nominal GDP growth is again 73.3% and the fixed-basket (CPI
based)
measure of inflation is 66.6%, now the fixed basket measure of real GDP
is 4% rather than the higher 6.66% obtained by using the fixed-weight
method.
In fact:

y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.666)] -1 = 0.04

How can we compute directly the real GDP growth if we use the CPI
deflator
? Simple: compute real GDP in the second period by taking period 2 as
the
base year (rather than period 1 as in the fixed-weight method). Then:

You see that, depending on which deflator we use, our estimate of
real
GDP growth will be different (6.66% versus 4%).

So which method is better ?

The point is this: there is no unique or best way to separate
relative
price movements from general movements in the price level, even in
theory.
This problem involves some subtle issues about price measurement, like
what quantities to use, date 1 or date 2. How much difference does this
make in practice? Some, but in high inflation periods, especially, the
movements in different prices indexes are similar. You can see this
from
the graphs of the CPI and GDP deflator in levels and rates of change (Figure
8 and Figure 9).

Note also that, the fixed-weight method used by the US until 1995
had
the disadvantage that it was giving too much weight in the calculation
of real GDP to the good whose relative price had fallen over time (in
this
example chips). Because of this bias, the value of the real output of
chips
was overestimated and led to an overestimation (6.66%) of the value of
the growth rate of the economy.

To see this issue in more detail consider the following example:

Price of Chips

Quantity of Chips

Price of Fish

Quantity of Fish

Date 1

1

10

1

10

Date 2

0.5

20

2

5

In this example:

Date 1 Nominal GDP = 20 (= 1x10+1x10)

Date 2 Nominal GDP = 20 (= 0.5x20+2x5)

Note intuitively that, in this example, real GDP has not changed in
period 2 relative to period 1. In fact the share of the 2 goods in
nominal
output is 50% and the quantity produced of one good (chips) doubled
while
the quantity of the other was cut by half.

So, what happens when we estimate real growth of GDP using the
fixed-weight
and CPI methods ?

Fixed-weight approach:

Date 2 Real GDP (in date 1 prices) = $ 25 (= 1x20 + 1x5)

Real 'fixed weight' GDP growth: 25% = (25/20)-1

GDP deflator inflation: -20%

Nominal GDP growth = 0 = (20-20/20) = (1 - 0.2)(1 + 0.25) -1

CPI (fixed basket) approach:

CPI inflation: 25% = [( 0.5x10 + 2x10) / 20] -1

Period 1 Real GDP using date 2 as the base year: 25

Period 2 Real GDP using date 2 as the base year: 20

Real GDP growth using date 2 as the base year: -20%

Nominal GDP growth = 0 = (20-20/20) = (1 + 0.25)(1 - 0.20) -1

The problem is that in fixed-weight approach, too much weight is
given
to production of the good (chip) whose price has fallen over time. If
we
use a fixed-weight method, the output level and growth rate is biased
upward
(we get an estimate of 25% real growth) because we are overestimating
the
value of the output of the good whose price has fallen.

It is like computing the real output of a PC computers in 1997 by
taking
the 1987 price of an equivalent machine (approximately $6,000) as the
base
for valuing the real value added of a PC that is priced only at $2,000
today. It does not make sense to value the quantity of computers
produced
today at prices that were prevailing 10 years ago. So, the fixed-weight
method led to an overestimation of the value added of the computer
industry.

When the U.S. relied on the fixed-weight method, it was giving too
much
weight in the calculation of real GDP to the good whose relative price
had fallen over time (in this example chips and in reality computers,
semiconductors
and other high tech sectors of the economy). Because of this bias, the
value of the real output of chips was overestimated and led to an
overestimation
of the growth rate of the economy. This issue became serious over the
1980's
as the price of computers was falling in absolute and relative terms
while
the fixed-weight, by using the high prices of computers prevailing in
the
base year, was leading to an overestimate of the real GDP created by
computers.
In order to eliminate such a bias, the Department of Commerce switched
at the end of 1995 to a chain-weight method of measuring real GDP. The
chain weight method is a combination of the fixed-weight method and the
fixed-basket method. Real GDP is estimated twice, first using the
previous
year prices as the base (fixed-weight) and the second time using the
current
year prices as the base and the previous year quantities to compute
real
GDP in the previous year. Then, a (geometric) average of the two is
taken.
Using this method:

Growth rate of chained GDP = [(1 + 0.25)(1-
0.2)-1]/2
= 0

i.e. the growth rate of chained GDP is equal to zero that is the
sensible
economic answer since real output in the example above had not changed
in a substantial sense.

There are however several potential problems also with the
chain-weight
method:

1. Quality changes are not correctly measured (examples: computers,
light) leading to under-estimate of the product of industries where
such
quality changes occur.

2. Major productivity growth in the service industries (ATM's,
telecommunications,
quality of health care) not measured by standard GDP measures.

First, an important issue in computing price indexes is how they
deal
with quality change and new goods. One of the facts of life in growing
economies is that the goods change: candy bars change size, PCs have
ever-increasing
capabilities, and some goods simply didn't exist in the base period.
Candy
bars are the easiest: we simply regard a five oz bar as half a ten oz
bar.
But what about PCs? If a 286 sells for $2000 and a 386 for $4000, has
there
been inflation or is the 386 machine twice as good as the 286? It's
even
more difficult if the commodity has no counterpart in the base period.
How do we include VCRs in the calculation when they didn't exist, for
all
practical purposes, prior to the 1980s? For this reason, some people
think
that price indexes and real GDP do not adequately reflect quality
improvements---that
real GDP is growing faster than we think because quality is constantly
improving. That's especially true now of new high-tech capital goods.

Second, related issues show up in services. Many authors (including
the Fed Chairman Alan Greenspan) have argued that major productivity
growth
in the service industries are not measured by standard GDP measures.
Moreover,
there are other subtle measurement issues: if the price of one hour of
a lawyer's time goes up, does this represent an improvement in quality
or just a rise in the price?

Critics of the switch from fixed-weights to chain-weights have
argued
that, while the fixed-weight method overestimated the contribution of
computers
to real GDP, the chain-weight method fixes one problem but does nothing
to address the two issues above; that, on net, leads to an
underestimation
of real GDP. So the new measure might overall tend to underestimate GDP
and its growth rate.

At the same time, a number of authors have argued that the use of
the
CPI inflation rate also tends to overestimate the true level of
inflation
rate in the US economy because of a number of biases. In December 1996,
the Boskin
Commission appointed by the Senate Finance Committee, reached the
conclusion
that the CPI overstates the true inflation rate by 1% to 2% per year.
Note
that, if inflation is overestimated, then our measure of real GDP
growth
is underestimated as well as more of the growth of nominal GDP is
imputed
to an increase in prices than to an increase in quantities produced. A
wide debate
on the CPI has followed the publication of the Boskin
Commission
recommendations. Fed Chairman Alan Greenspan has expressed his views on
this debate in a testimony
in Congress in January 1997 and a recent speech
in November 1997.

Bottom line: economic indicators clearly contain useful
information,
but
like accounting statements they must be interpreted with care. [Data
are
like sausages: if you like them, you shouldn't think too much about
what
goes into them.]

Further Readings

On paper, there are two good (by which I mean informative and
readable)
books on the uses, sources, and meaning of economic data: Norman
Frumkin's
Guide
to Economic Indicators (Armonk: Sharpe, 1994, 2nd edition) or Tracking
America's Economy (Armonk: Sharpe, 1992). Not needed for this
course,
but if you ever have to look something up it's a good place to start. A
slightly more technical introduction to macroeconomic data is available
from the Richmond Fed: Macroeconomic Data: A User's Guide,
edited
by Roy Webb. Both of these cover the
US, but in many cases the methods are similar to those used in other
countries
(especially for national income and product accounts, for which there
is
a United Nations standard).

Entries are percentages, averages of quarterly data over the period
1970:1 to 1989:4. Data are from the OECD's Quarterly National Accounts,
seasonally adjusted, except US, from Citibase. Variables are: Y = GNP
or
GDP; S = Y-C-G, where C is consumption and G is government purchases of
goods and services; I = gross fixed capital formation. All variables
are
measured in current prices. Numbers may not sum to zero because of
rounding,
and because my measure of investment does not include the change in
business
inventories.